| TSG Weekly Market Watch July 20, 2007 |
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| Written by Matt Blackman | |||||||||||||||||||||||||||||||
| Sunday, 22 July 2007 | |||||||||||||||||||||||||||||||
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TSG Stock Market LetterWeek Ending July 20, 2007TradeSystemGuru.com Topics Discussed This Week:
In our last macro-view (July 6) we took a brief excursion into the mysterious and complex world of derivatives and saw how quickly the Over-the-Counter derivatives market has grown over the last decade (see http://tradesystemguru.com/content/view/66/58/ )
Figure 1 – Chart showing rapid growth in credit default swaps (CDSs) compared to equity derivatives. Between 2005 and 2006 CDSs doubled from $17.1 trillion to $34.4 trillion which demonstrates how quickly they’ve become popular since their initiation in 2001. As we discovered, the rate of global growth for derivatives has continued at a breakneck pace. Total OTC derivative dollar volume is estimated to surpass $500 trillion by the end of 2007. As we see from Figure 1, credit default swaps (CDSs) are the fastest growing derivative segment and at the current rate of growth they are set to total nearly $70 trillion by the end of the year. Fathoming the Sub-Prime SwampIf you’re like me, you’ve been hearing increasing references to the ABX indexes used to track sub-prime mortgage bonds. The ABX-HE indexes are windows into the shrouded world of sub-prime mortgages and provide a pulse on the health of that segment as well as insights into the strength of the overall housing market. Before asset-backed-securities (ABS) existed, investors wanting to play the commercial mortgage game had few options. Shorting a position or obtaining insurance in the form of a credit-default swap (CDS) were out of the question. Enter the asset-backed credit default swap or ABCDS that allowed investors to do both.
Figure 2 – Composite chart of the fifteen mortgage-backed securities sub-prime credit default swaps (CDSs) contract indexes available since January 2007 from AAA (Figure 3) to BBB (see Figure 4) tracked by Markit.com. As a group, they are down 23% since initiation on January 1 and 16% since June 1 with the greatest drop occurring in the last two weeks. Markit.com then launched of a family of credit default swaps based on the U.S. sub-prime asset-backed securities called the ABX.HE indexes which provided derivatives investors with a new trading tool. But perhaps more important to the broader markets, a way of gauging the ongoing health of the sub-prime market and those investment banks, brokers, hedge funds and institutional investors that participated in it. Each ABX index was set with a value of 100 at the beginning of January 2007 and tracks different series of sub-prime mortgage bonds from triple A (highest rated) to triple B minus (lowest grade or junk). In effect ABX indexes measure the value of insurance policies held by those who collect a premium to insure the various traunches of CDO bonds in case of default (kind of like the folks that put up their assets to back Lloyds of London insurance policies in return for a small annual premium). While the market was humming along and defaults remained small, the ‘insurers’ collected their premiums and put it in the bank. Up until the end of 2006, there were more insurers who saw it as a way to make easy money than there were investors wanting coverage. As we see from Figure 3, those highest rated have held up reasonably well. Since some CDO traunches contain as many as a million separate mortgages, having a few defaults was no big deal. Problems arose when defaults began to occur en masse. As we see from Figure 4, insurers backing the lowest grade triple B CDS have been getting hammered. Since January, (Friday’s close was 42.10) have dropped nearly 60% in value. But for those seeking to buy insurance on riskier CDOs, it meant that insurance costs had more than doubled in just seven months.
Figure 3 – ABX triple A index representing the value of the highest level of sub-prime mortgage-backed security CDSs showing the recent drop in light of the Bear Stearns hedge fund revelations.  Figure 4 – Chart of the index of the triple BBB minus or riskiest subprime mortgage CDSs showing the gut-wrenching drop since the beginning of the year. Wonder how far above zero this index will level out? Paying more than double for insurance on a triple B sub-prime investment than it cost at the beginning of the year may sound expensive but it is no doubt a bargain for sub-prime CDO traunch holders looking for salvation, especially after the news this week that investors in two failed Bear Stearns sub-prime hedge funds will get little if any money back. And growing mortgage risks were made even more poignant this week with news from Miami, the national foreclosure ‘epicenter,’ that there are now 20,000 new condo units being built, up from 12,000 units in April (see Miami Condo Glut below). Just to give you an idea of how many that is compared to historic demand, in the decade leading up to the year 2000, the Miami market aborted an average 1,000 units per year. Rising condo inventories have prompted forecasts for a 30% price drop from industry experts and amazingly building new projects continues at a hectic pace. This situation promises to get more interesting by the week. What the ABX-HE indexes provide is a way of taking an insider’s look at the sub-prime market. They greatly increase the transparency of those complex sub-prime derivatives, making it easier for investors who want to buy or sell them. These indexes will also make it more difficult to keep future failures from the public. We will be checking in on the ABX indexes periodically to track how they are doing. Markit.com introduced another five indexes this week providing a broader look at the sub-prime market. Stay tuned. Related Reading Background article on the ABX-HE Index http://www.creditmag.com/public/showPage.html?page=323419 ABX index information and documentation Miami Condo Glut Pushes Florida's Economy to Brink of Recession http://www.bloomberg.com/apps/news?pid=20601010&sid=a4qa.rYTWyYA&refer=news April 6 newsletter discussing Miami market melt http://tradesystemguru.com/content/view/35/58/#Miami Now let’s check in on what happened in stock markets over the last week.
SummaryAfter a couple of failed attempts, the Dow finally closed above the psychological hurdle of 14,000 as it squeaked to a 14,000.41 close on Thursday. But not surprisingly, the surge motivated profit taking and the index dropped nearly 150 points on Friday. However, more bad housing data and news that Bear Stearns sub-prime hedge investors would see little if any money of their money back failed to rattle markets to any great extent. But it this just a delayed reaction or a sign the the bulls will not be swayed no matter what happens? Technically SpeakingLast week, the normally boring summer market came alive as indexes across the board performed much to the pleasure of long investors. While the Dow Industrials dropped this Friday, it is still engaged in an uptrend. On a weekly basis the index continues to build a healthy stairstep pattern. However, there is little doubt that the market could use a rest at this point after moving ahead at such an impressive rate. Since putting in its 2006 low July 14, 2006, the Dow has added nearly 26% and in the process has broken above its 2 standard deviation trend channel top line, while the S&P500 and NYSE Index are glued to the top and above their upper trend channels respectively. As well the Nasdaq Composite, Dow Transports, Dow Utilities and Russell 2000 are above their long term trend channel midlines which is good – almost too good.
Figure 5 – Composite chart of market Dan Zanger’s leading stocks as of July 18 over the last month that include the likes of Google, Apple, Research in Motion and Baidu.com compared to the S&P Spydrs ETF (SPY). They have gained 12% versus less than 2% for the S&P. As you can see the leaders started to roll over this week in advance of the broader market suggesting caution until till they resume their uptrend. The Nasdaq Composite looks like it may be getting ready to take a break this week and Dan Zanger’s market leaders (see Figure 1) discussed last week are also flashing a caution signal as they looked to be cooling off. They may be trying to tell us that the market is getting ready for a much needed correction. These stocks began a similar consolidation in December 2006, nearly two months before the last major correction at the end of February, before resuming their uptrend in early March providing ample warning of the drop. After taking a break Monday and Tuesday, commodities resumed their rally pushing the NYFE CRB Index up to 423.48 up slightly on the week from 423.39 last Friday. Gold continued to rock’n roll partly thanks to weakness in the dollar and a flight to quality in the wake of Bear Stearns hedge fund revelations. Gold closed the week back where it was in May but more importantly from a technical standpoint, it continued to build on its bullish catapult or ‘W’ pattern that we pointed out last week. The yellow metal closed Friday at $684.60 up from $667.30 last week and $654.70 two weeks ago. Gold is now in a period of seasonal strength that could well last through the end of the year, especially given the weakening dollar and growing economic challenges. Finally, we are still in the pre-election year in which governments shamelessly pump up markets and economies in a not unsubtle attempt to get re-elected. Their efforts have proven inflationary which is also good for commodities and gold in particular. This lift generally lasts until the election providing gold bugs with more good reasons to horde their favorite metal. It was another challenging week for the greenback as the U.S. Dollar Index has steadily declined. It closed the week at 80.15 down from 80.39 last week and 81.69 three weeks ago. Last week it hit a twelve-year low and this week it fell to a 15-year low. It was the sixth strong week for oil as the NYMEX crude oil (continuous) surged to close at $75.79 up from $74.13 last week and $73.15 two weeks ago. Oil prices have increased 46% since the January 18th low of $51.81 and high prices will continue to exert negative pressure on consumer spending. Emerging markets continued to exhibit trong performance and this week it was revealed that China’s GDP growth surged to the fastest rate in a decade as it hit 11.9% for Q2-07. This was positive for the MSCI Emerging Market Index ETF (EEM) as it put in a bull flag consolidation pattern this week. The ETF closed at 139.98 down slightly from 142.75 last week but up from 138.30 two weeks ago. EarningsAfter two weeks of the reporting season and with 742 companies now having reported Q2-07 earnings (up from 440 last week), net income improved 6% versus Q2-06, compared to 4% last week and 8% for Q1-07 (versus the year before). While earnings are below the seasonal average for Q1-07, they are above where they were after the second week in Q1-7 reporting season when improvement averaged 4%. These data are not just from S&P500 companies but more than 4000 companies that report earnings tracked by the Wall Street Journal, so a broader look at corporate health. Economic ReportsHere’s what the charts had to say this week.
Chart 1 – On Tuesday (July 17) it was reported that the National Association of Home Builders Home Market Index survey of 330 builders dropped for the fifth consecutive month in July to 24, a low not seen since January 1991. The three components that make up the index broke down as follows: new home sales dropped to 24 from 29, sales expectations for the next six months dropped five points to 34 while the traffic of prospects through show homes and sales offices dropped three points to 19. Showing that his hindsight is 20-20, the NAHB chief economist David Seiders had this to say in a prepared statement. “The bottom line is that the single-family housing market is still in a correction process following the historic and unsustainable highs of the 2003 – 2005 period.” But being a cheerleader who has to earn his keep, Seiders did his best to put a happy face on the grim situation saying that he expects home sales to get back on “an upward path” later this year with the market beginning a gradual recovery next year. There is no support for this hope in the chart below. His latest claims made me think of the story about the boy who cried wolf a few too many times.
Chart 2 – Got an interesting insight into record keeping at the Census Bureau this week with regards to housing permits and housing starts. It was reported in the Wall Street Journal on Wednesday that housing starts jumped 2.3% in June. We checked the Census Bureau data we downloaded last month and discovered that starts actually were down 4.8% for the month not up 2.3%. After checking the most recent seasonally adjusted data, we realized that the Census Bureau had revised the May starts down from 1,474 to 1,424, making no mention about the revision that we could find. Last month’s housing starts drop of 2.1% was in reality a drop of 4.7% after revision. Meanwhile May building permits, a better leading indicator of upcoming building activity, was revised up to 1,520 from 1,501 but June permits fell to 1,406 – a drop of 7.5%! I found scant mention of that in the financial news. These covert revisions provide another good reason not to take economic monthly changes (or a number of government indicators for that matter) too seriously. Sweeping away all the government statistical slight of hand, this chart clearly shows that permits generally lead and both permits and starts still look to be on a steep slippery slope lower.
Chart 3 – A metric we recently started to follow shows international Treasury capital flows or the amount of buying of U.S. Treasuries by foreigners each month. This chart bears close scrutiny because a trend showing a reduction of Treasury purchases by foreigners will push yields on everything from 90-day to 30-year Treasuries higher and bank prime rate along with it regardless of what the Fed may be doing with the Fed funds rate. Treasuries got a lift this week with the flight to quality in buying bonds pushing bond prices higher and yields down. The question is, how long will foreigners continue to buy our bonds if the dollar continues to fall? Next WeekHere are the economic reports we’ll be watching. - Wednesday, June existing home sales (previous -0.3%) and Beige Book report. - Thursday, June durable goods orders (previous -2.4%) and June new home sales (previous -1.6%). - Friday, Q2-07 advance GDP (previous: +0.8%). SynopsisOur synopsis last week focused on the growing collateral debt obligation (CDO) fallout and that was before the most recent revelation that the assets in at least one of Bear Stearns’ sub-prime hedge funds are virtually worthless. We also examined the practice of something we’ll call sales price padding and that is incentives offered by sellers of both existing and new homes to buyers: many of which are not reported. While it is nearly impossible to determine how prevalent the problem is, it is easy to measure in new homes. As mentioned last week, incentives now offered by Lennar Corp. one of the nations’ largest homebuilders, averaged $43,700 a home in Q2-07 up from $24,700 in Q2-06. The median price for new home sold in the U.S. was $236,100 in May according to the Commerce Department. This means that the reported price of the average new home is more than 18% higher than it should be. According the National Association of Realtors, the median selling price for an existing home in May was $223,700 down 2.1% from May 06 (let’s forget about the inherent problems tracking median prices for this exercise). An 18% incentive would amount to $40,000 per home. Whether it’s higher or lower in reality, the point is that reported prices include these incentives making them artificially high. As a greater number of homes are sold through foreclosure and auction, these incentives will be removed (since cash payments between sellers and buyer are usually illegal which banks and auction houses would not risk). This means we should expect not only to see downward pressure in home prices as incentives are targeted (by law enforcement and regulators), there will be further downward market pressure on prices as a result of forced sales. Now hold that thought for a moment… Ben Bernanke made an impact in his testimony on Capital Hill this week with his answer to a question regarding the macroeconomic effect of homeowners no longer being able to use their home equity as a quick source of cash. While Mr. Greenspan advocated that a fall in mortgage equity withdrawals (MEWs) would impact consumer spending, Bernanke instead believes that the biggest risks lie in falling home prices. “Our sense, and this so far seems to be borne out by the data, is that consumers respond to changes in the value of their home essentially because there’s a change in their wealth, not because there’s a change in their access to liquid assets…. House prices, nationally speaking, have not declined. They’ve only risen more slowly, and so we have not yet seen anything except in a few local areas akin to a decline in house prices,” he said in his testimony. In a few sentences he disavowed two principles that many consider economic fact: first, that mortgage equity withdrawals have helped fuel consumer spending (and economic growth) and second, that home prices are falling. When Ben said that “house prices, nationally speaking, have not declined,” he must have been referring to new home prices. Prices for existing home sales (representing 85% of the market) are certainly falling. According to National Association of Realtors, median existing home prices dropped 1.26% in April 2007 from a year ago which is about half of the drop shown by the more reliable S&P Case-Shiller index showing a drop of 2.13% over the same period (please see the discussion and chart in our June 29 issue at http://tradesystemguru.com/content/view/64/58/#Discrepancies ) Only new home prices are now higher than they were in 2006. But we also know that new homes prices have been kept artificially high by builder incentives. NAR figures show that the median price of an existing home droppped 2.1% in May from the previous May: a statistic of which Mr. Bernanke is either unaware or discounted. But with foreclosures and unsold inventories continually rising combined with spreading fall-out from the sub-prime fiasco, one would have to be out of touch with reality to assume that new and existing home prices will simply level off. Just look at Florida, one of the hottest regions in the U.S. from 2000 to 2006. Housing and apartment prices are now expected to drop by as much as another 30%. According to the NAR, national existing home inventories in May increased to 4.43 million homes which is an 8.9 months supply at the current sales rate, up from 8.4 months in April. Unless he was just having an off day, these recent statements qualify Chairman Bernanke as a bona fide member of the housing-melt-denial/soft-landing cadre joining such esteemed notables as Jim Cramer, Larry Kudlow, past NRA cheerleader David Lereah and his replacement as chief economist and sales stoker Lawrence Yun as well as a host of mortgage, brokerage and mortgage industry talking heads interviewed in any week on financial news television. But they all have vested interests in putting a positive spin on the housing situation. What’s Mr. Bernanke motivation? Does he plan to use this argument to justify future rate hikes (which is really what is needed now, despite what realtors, mortgage brokers and builders would have you believe) or is there other motivation? It is worthwhile mentioning that the Fed and Mr. Bernanke have previously downplayed the potential fallout from the sub-prime fiasco in past testimonies stating at the time that the problem was contained. That rhetoric went completely out the window in his testimony this week when he admitted to Congress that conditions in the sub-prime market “have deteriorated significantly.” Unless there is a miraculous housing recovery in the next few months, chances are high that the Fed will be forced to admit to a similar change of heart on that issue as well. Nevertheless, having the Fed Chairman (as well as the whole team of analysts and regional heads at the Fed who follow his lead) in denial about both the impact on the economy by mortgage equity withdrawals and the true state of the housing market, especially given their reliance on such flawed inflation metrics such as the CPI, PPI and the PCE deflator, can’t be a good thing for getting a realistic evaluation from the institution of the economy and market going forward. Like the sub-prime situation, by the time the Fed finally admits that home prices are falling and revises its outlook, it will be too late for those investors who relied on Ben’s calming assurances that the consumer and economy would continue to be strong. ------------------------------------------------------------------------------------------------------ If you find this newsletter insightful, please feel free to forward this newsletter and share it with a friend (or simply have them opt-in free from our home page http://www.tradesystemguru.com to be added). DisclaimerTradeSystemGuru.com obtains information from sources deemed to be reliable; |
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